The curious case of the inverted yield curve in China's $1.7 trillion bond market is worsening as WSJ notes that an odd combination of seasonally tight funding conditions and economic pessimism pushed long-dated yields well below returns on one-year bonds, the shortest-dated government debt.
10-Year China bond yields fell to 3.55% overnight as the 1-Year yield rose to 3.61% - the most inverted in history, more so than in June 2013, when an unprecedented cash crunch jolted Chinese markets and nearly brought the nation’s financial system to its knees.
This inversion is being exacerbated by seasonally tight funding conditions.
June is traditionally a tight time for banks because of regulatory checks, and, as Bloomberg reports, this year, lenders are grappling with an official campaign to reduce the level of borrowing as well.
Wholesale funding costs climbed to the most expensive in history, and the 30-day Shanghai Interbank Offered Rate has jumped 51 basis points this month to the highest level in more than two years.
And this demand for liquidity comes as Chinese banks’ excess reserve ratio, a gauge of liquidity in the financial system, fell to 1.65 percent at the end of March, according to data from the China Banking Regulatory Commission. The index measures the money that lenders park at the PBOC above and beyond the mandatory reserve requirement, usually to draw risk-free interest.
“Major banks don’t have much extra funds, as is shown by the excess reserve data,” analysts at China Minsheng Banking Corp.’s research institute wrote in a June 5 note. Lenders have become increasingly reliant on wholesale funding and central bank loans this year, they said.
As The Wall Street Journal reports, an inverted yield curve defies common understanding that bonds requiring a longer commitment should compensate investors with a higher return. It usually reflects investor pessimism about a country’s long-term growth and inflation prospects.
“But the curve inversion we are seeing right now is one with Chinese characteristics and it’s different from the previous one in the U.S.,” said Deng Haiqing, chief economist at JZ Securities.
The current anomaly in the Chinese bond market is partly the result of mild inflation and expectations of a slowing economy, Mr. Deng said. “At the same time, short-term interest rates will likely stay elevated because the authorities will keep borrowing costs high so as to facilitate the deleveraging campaign,” he said.
Notably, it appears officials are concerned at the potential for fallout from this crisis situation.
In an article published Saturday, the central bank’s flagship newspaper, Financial News, said that the severe credit crunch four years ago won’t repeat itself this month because the central bank will keep liquidity conditions “not too loose but also not too tight.”
Chinese financial markets tend to be particularly jittery come June due to a seasonal surge of cash demand arising from corporate-tax payments and banks’ need to meet regulatory requirements on capital.
On Sunday, the official Xinhua News Agency ran a similar commentary that sought to stabilize markets expectations. “Don’t panic,” it urged investors.
Sounds like exactly the time to 'panic'.